Picture this: It’s Black Friday 2022, your favorite designer is having a sale, and you can’t wait to treat yourself with something new. Meanwhile, your retirement account is down 20% and you wonder why even bother investing? But aren’t stocks on sale now also? They don’t provide the same instant gratification, but why don’t we treat them the same?
2022 was a year that challenged many portfolios. While painful to experience in real-time, it’s helpful to review how you reacted to volatility and remember the importance of a financial plan. Behavioral finance emerged from psychology to better understand why people make suboptimal choices when faced with complex decisions. What these studies revealed were the biases and cognitive errors humans make under duress.
It all sounds simple to start. You work hard and save money, hearing it may grow on average 8% per year. But rarely does the market produce average returns. Sometimes it’s a great year up 21% (2017) and sometimes it’s down 9% (2000). Or you may be up 37% (1995) or down 37% (2008). Traditional finance assumes that investors will act rationally through all of this. They will buy and hold through the volatility just fine, but we are not always rational.
Psychologist Daniel Kahneman refers to two modes of thinking, System One and System Two. System One reacts quickly and is based on our ancestors years ago. When something looked like a lion, they did not wait, they took off running. System Two is the deliberate part of our brain that uses logic to determine if it actually is a lion. It also can be draining but is necessary to determine if System One’s analysis is valid.
Like our ancestors avoiding predators, investors experience a desire to sell everything to avoid further losses during downturns. We may be feeling different emotions throughout all of this. Understanding why we feel the way we do is the first step in controlling biases and avoiding errors.
Here’s how these biases might play out in real-time. In a down market, we first experience the availability or recency bias, where an investor gives more weight to recent events expecting them to continue. We think the market will decline further and sell irrationally. We could hold cash, or we could chase something that's performed well recently. We kick ourselves for not having done so sooner when it was obvious, known as hindsight bias. If another investment trend is booming, we jump on the bandwagon, leading to a herd mentality. Even better, a prominent financial guru is touting how great it is, so you buy based on the halo effect.
Rarely are decisions evaluated within the context of your financial plan. This scenario is an example of how investors can be their own worst enemies. Having an independent financial advisor who understands your risk tolerance, time horizon and goals is essential to keeping you on the right track, so you’re prepared for the next Black Friday sale.
About the Author
Chuck Posnecker joined Cypress Capital, now Bryn Mawr Capital Management, in 2017 after working for Christiana Trust, a division of WSFS Bank, for 12 years in their personal trust and investment groups. He graduated from the University of Nevada, Las Vegas, where he received his BSBA in International Business (2002) and MBA-Finance concentration (2005). Chuck is also a graduate of the Pennsylvania Bankers Association School of Trust, Investments & Relationship Management, where he completed a three-year program focused on various aspects of trust administration and investments. Chuck obtained his Certified Trust & Financial Advisor designation in 2011, his Chartered Financial Analyst designation in 2016 and earned the CFP® certification in 2019.
Disclosure
This article is provided by Bryn Mawr Capital Management, LLC ("BMCM") for informational purposes only. Investing involves the risk of loss and investors should be prepared to bear potential losses. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. No portion of this commentary is to be construed as a solicitation to buy or sell a security or the provision of personalized investment, tax or legal advice. Certain information contained in this presentation is derived from sources that BMCM believes to be reliable; however, BMCM does not guarantee the accuracy or timeliness of such information and assumes no liability for any resulting damages.
Bryn Mawr Capital Management, LLC. is an SEC registered investment adviser and a subsidiary of WSFS Financial Corporation. Registration as an investment adviser does not imply a certain level of skill or training. INVESTMENTS: NOT A DEPOSIT. NOT FDIC – INSURED. NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY. NOT GUARANTEED BY THE BANK. MAY GO DOWN IN VALUE.
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